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paid by the guaranty system because of these limits. To the extent the policy obligates the insurer for coverage in excess of the maximum recovery under the guaranty fund law or coverage of the guaranty fund deductible amount, the policyholder is a general creditor of the failed insurer entitled to pro rata payment upon liquidation.

The NAIC does not have available to it aggregate figures for policyholder losses attributable to deductibles and maximum recovery limits. Again, the length of time involved in settling the affairs of insurers would compound the task of compiling total losses to policyholders determined after the insurer is liquidated.

However, it is clear that clairs in excess of othe maximum recovery lit under the guaranty funds are, a should be expected, exceptional. for example, with a $1 million limit on its property-casualty security fund, New York, has never had a claim in excess of the limit. Calonia sivilarly, with a $500,000 maximum recovery limit in its property-casualty guacenty fund, has had no claims in excess of its limit.

Part of the rationale in including deductibles in the guaranty fund cover ges is to minimize costs which are assessed, in effect, to policyholders of other insurers. Policyholders of insolvent insurers, by way of the deductibles, bear some of the financial consequences of selecting the insurer that becomes insolvent. We do not believe that the deductible significantly diminishes the broad protection afforded by the guaranty fund, while at some time it allows the economical operation of the fund.

4.

In an article by Jack H. Blaine appearing in the Spring 1977 edition of Forten, state guaranty plans seem to be plagued by constitutional and other legal problems. Could these serious and continuing legal difficulties compromise the effectiveness of state guaranty funds?

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We do not agree that Mr. Blaine's article raises "serious and continuing legal difficulties." The issue of retroactivity discussed in that article will obviously be self-eliminating after a period of time. This is not in any way a continuing legal problem that can threaten the viability of the state systers, but rather raises questions on a state-by-state basis of application to past, not future, circumstances.

As far as constitutional issues are concerned, it has long been recognized that the insurance business vitally affects the public interest (Geriau Alliance Ins. Co. v. Lewis, 232 U.S. 389 (1914)). process issues, the Supreme Court in 1951 upheld a California assigned risk In deciding various due plan and recognized that in the insurance field, "the power of the state is broad enough to take over the whole business, leaving no part for private enterprise" because of the affected public interest (California Auto Assn. v. Maloney, 341 U.S. 105, 110 (1951)). More directly, in Maloney the court

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recognized the similarity of the California assigned risk plan under which insurers equally share bad risks to a guaranty fund. The court relied on Maloney in its decision in Noble State Bank v. Haskell (219 U.S. 104 (1911)), which sustained a state law assessing each state bank for the creation of a depositor's guaranty fund (Maloney at 109). These decisions leave virtually no doubt as to the power of the state to mandate insurers' participation in insurance guaranty funds.

Other than the Arizona Supreme Court decision that a previous Arizona Guaranty Food bill was unconstitutional (because it was created by "special law"), no state law has had its guaranty fund law declared unconstitutional. The Arizona case, Firemans Fund Insurance Co. v. Arizona Tsuruce Guaranty Association (536 P 2d 695), was decided on a narrow issue, and that act has since been replaced by an act that was drafted to overcome the prior constitutional infirmity. There is virtually no basis for suggesting that the constitutionality of state guaranty fund laws has been cast in doubt by legal challenges.

Specifically, the cases noted in Mr. Blaine's Forum article do not give rise to reasonable concerns over the viability of state funds. O'Malley v. Fla. Ins. Guaranty Ass'a. (257 So 2d 9 (Fla 1971)) upheld the constitutionality of the Florida law, and the U.S. Supreme Court denied certiorari despite a plea that the decision had constitutional implications in other states.

The Iowa decision, Osborne v. Edison (211 N.W. 2d 696 (Iowa 1973)), was not a challenge of the Iowa act but rather determined the meaning of language contained in the act. Judicial clarification of statutory language is hardly unique to the states nor is it unexpected.

The Washington decision, Actna v. Washington Life and Disability Insurance Guaranty Association (520 P 2d 161 (1974)), upheld the constitutionality of the Washington statute. According to the Washington Supreme Court, differences in treatment of foreign and domestic insurers did not render the Washington act unconstitutional since there was a rational basis for such differences.

A review of these and other challenges of state guaranty funds does not in any way support the contention that state guaranty fund laws are plagued by legal difficulties. To the contrary, it is abundantly clear that such enactments are lawful and proper state controls over the insurance business and insolvency problems.

Sincerely,

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WESLEY J. KINDER
Insurance Commissioner

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I - HOW THE EARLY WARNING SYSTEM WORKS

The NAIC Early Warning System, developed by a committee of state insurance regulators, is intended to assist the various state Insurance Departments in identifying property and liability insurance companies requiring particularly close surveillance. The system is based on eleven audit ratios, or tests, which have been shown to be effective in distinguishing between financially troubled and sound companies.

This chapter describes the purposes of the Early Warning System, the method of identifying priority companies, and the reports provided by the system.

PURPOSES OF THE SYSTEM

The purposes of the Early Warning System are to help state Insurance Department personnel quickly identify companies requiring close surveillance and determine the form that surveillance should take. The system is not intended to replace in-depth financial analysis or on-site examination of companies. It can, however, provide a guide to those companies for which deeper analysis may be required. It can also serve as an aid in determining which companies may require special on-site examinations, either to resolve specific issues or to verify overall financial solidity.

Although the system has been shown to be effective in distinguishing between troubled and sound compames las discussed below), it is by no means foolproof. This fact has two important implications:

1. No state should rely completely on the Early Warning System as its only form of surveillance.

2. Loportant decisions such as licensing decisions

should not be

besed on augst ratio test results with ad further analy-is and
esa pination of the ompany oncerned.

SELECTION OF

PRIORITY COMPANIES

By comparing the test results for all companies in 1972 with the results for companies becoming insolvent during the past five years, a "usual range" of test results has been determined for each of the individual audit ratios. Companies falling outside this usual range on four or more of the eleven tests (not including the one-year version of the operating ratio) are treated as priority companies. Companies falling outside the usual range on no more than three tests are treated as nonpriority companies.

Nationwide, between 10 and 15 percent of the companies tested are expected to receive the priority company designation. These are the companies most likely to require closer than usual monitoring by the Insurance Department. Their test results should be verified, and further analysis of their annual statements should be performed to determine whether an onsite examination is called for.

Although the intent of the priority company system is to assist Insurance Department personnel in focusing their immediate attention on those companies most likely to be experiencing financial difficulty, not all the priority companies will necessarily be troubled. Some may have taken action to eliminate weaknesses that became apparent during the prior year. It is also possible that unusual accounting methods may make test results appear less favorable than is warranted, or that errors may occur in calculating test results. However, unless a given priority company is known to be financially sound, careful analysis and examination of that company would be appropriate.

Nonpriority companies are less likely to require in-depth review or on-site examination. However, the fact that a company is not given the priority classification by the Early Warning System should not be taken as a guarantee of continuing financial solidity. The results of individual tests for each nonpriority company should be carefully analyzed. If areas of concern are identified, a review of that company's annual statement should be made to determine whether an examination is required.

Over the past half decade, more than 80 percent of the insolvent companies whose annual statements were available for three years before insolvency would have been classified by this system as priority companies; half of those not so classified experienced changes in ownership or control during their last three years. All but one of the insolvent companies studied would have been given the priority classification in their final year.

The one

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